RENTAL DEPRECIATION
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Your rental property depreciation knowledge base
DEPRECIATION RECAPTURE FOR REAL ESTATE AND RENTAL PROPERTIES
Property or business owners with valuable assets can deduct depreciation expenses from their annual income taxes. These deductions can save real estate investors considerable money in their annual taxes. However, it is crucial to remember that when you sell the property and get a profit, the Internal Revenue Service (IRS) will levy a tax on it. This post focuses on the ins and outs of depreciation expenses.
What is Depreciation Recapture?
Depreciation recapture is a mechanism in the Internal Revenue Code (IRC) that allows the IRS to collect taxes on the real estate investor's financial gains after selling a property. After buying an asset, for example, a car or building, the IRS allows you to deduct some value of the asset as it depreciates over time. Therefore, you will pay less in tax. The difference between the sale value and its depreciated value is accounted for upon selling the asset.
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Any gain realized from the sale of a capital asset should be recorded, reported, and taxed. However, the sale proceeds should be taxed as ordinary income instead of using the capital gains tax rate.
Depreciable Assets?
Depreciable assets wear out, lose value, become obsolete, decay, or get used up. It is essential to note that depreciation is only deducted from property or assets used for commercial purposes. Rental property is considered depreciable if:
It is used to generate an income
It can last before it wears out, and you can claim its ownership for at least one year.
It has a determinable useful life
You are the legal property owner
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However, not all assets are depreciable. Non-depreciable assets include:
Raw land because it can't wear out or become obsolete.
Rental properties an investor puts in service only to sell to another investor within the same financial year.
Leased property.
How Does Depreciation Recapture Work?
Depreciation recapture can impact your tax significantly after selling a residential property. A part of the profit can be taxed as ordinary income, thus qualifying for the maximum 20% rate in the long run. However, the part of the asset related to depreciation can be taxed at a rate of 25% in depreciation recapture.
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You are liable for depreciation recapture tax if you sell an asset or property at a profit. To determine the depreciation recapture tax, you need to calculate the depreciation of the property claimed during the ownership and multiply the total with the ordinary income tax rate. Luckily, the IRS publishes depreciation schedules for different assets to show permissible annual depreciation a taxpayer can claim on a property.
The Rental Property Depreciation Schedule
Investors can calculate the depreciation expenses, value their assets and calculate capital expenses using the depreciation schedule. The IRS depreciation schedule shows the type of depreciation an investor can take and deduct each year.
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The schedule shows a detailed breakdown of the land and building value based on the rental property's useful life allowed by the IRS. The IRS determines the assets and properties for which you can claim depreciation. For example, primary residence, landscaping, and land are not depreciable. It is essential to note that you can't claim depreciation for assets acquired, placed in service, and sold the same year you claim it is depreciable.
How Can You Calculate Rental Property Depreciation Recapture?
Step 1: Determine the cost basis of the property
Suppose you purchased a rental property five years ago for $100,000, including the title recording fees, closing costs, and other additional costs. If the lot value was $5,000 per the tax assessor when buying the property, the property cost basis is $95,000. Therefore, $95,000 is the amount that can be depreciated.
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Step 2: Calculate depreciation recapture
Residential properties are depreciated over 27.5 years, while non-residential assets are depreciated over 39 years. Assuming the property in the above example is residential, the depreciation expense is calculated by dividing the property's cost basis ($95,000) by 27.5 years. Then you can multiply the quotient (result) by the number of holding years. Over the five years, the depreciation expense claimed by the investor amounts to $3,454.54 per year and a total of $17,272.72 in five years.
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The depreciation expense reduces the total tax the investor pays to the state and federal government. The IRS will claim its money back after the investor has sold the property. The depreciation expense of $17,272.72 is recaptured and taxed as per the investor's expected income rate (up to 25%).
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Step 3: Determine the residual capital gains tax
The remaining capital gain tax is calculated by getting the difference between the original price of buying the property from the sale price. To reduce the profit subject to capital gains tax, the seller can deduce additional expenses like sales commissions and closing costs.
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If the rental property is sold at $150,000 the initial gain on the sale amounts to $50,000 ($150,000 - $100,000). Assuming the sales commission was 3% and closing costs 2%, expenses deducted expenses are $1,500 and $,1000. The rental property profit subject to capital gains tax is $47,500 ($50,000 initial gain - $2,500 deductible expenses).
Capital gains tax varies from one individual to another depending on their federal income bracket. Your capital gains tax rate can vary from 0% to 15% or 20%. Since calculating rental property depreciation recapture can be complex, you should consider hiring the services of a qualified tax accountant.
Final Thoughts
Depreciation is a meaningful way of saving money on taxes through an asset's useful life. Investors enjoy a greater cash flow when they own property because rental property depreciation delays taxes until you finally sell the property. It is essential to note that your property is subject to recapture whether or not you claimed depreciation.
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Finally, keeping track of capital gains and rental property depreciation is daunting. The cost basis may vary significantly due to capital improvements such as installing a new roof or other amenities. Sometimes, the property value might rise or fall depending on unpredictable real estate trends. To that end, getting a professional opinion on depreciating your assets can come in handy.